Technology

Trouble in Carlyle's Paradise

In 2004, William Kennard, the former Federal Communications Commission (FCC) chairman and managing director at The Carlyle Group, unveiled plans for the private equity firm to take over Hawaiian Telecom. He had high hopes. "The company was chartered by the King of Hawaii in the 1880s, and it has huge brand recognition," he said at the time. "We think that reconnecting the company to its local roots and empowering the company to make local decisions will create significant opportunities for growth" (see BusinessWeek.com, 11/2/04, "Carlyle's Hawaiian Adventure").

Carlyle closed the $1.65 billion deal in May, 2005. But to date, there's been scant evidence of the growth Kennard had hoped for. On Aug. 14, the company reported that second-quarter operating revenues declined 2.3% year over year, to $147.1 million. It lost $32.2 million for the period, compared with a loss of $56.7 million in the same period of 2005. The number of access lines, a benchmark for telecom companies, slipped 5.3% in the past year. And a new back-office system took two months longer than expected to implement and was beset by a round of glitches. "The quarter was tougher than I anticipated," says Dimitri Triantafyllides, an analyst with Wachovia Securities.

Kennard and top management are hardly deterred. They insist that with the back-office upgrade in place, they'll be able to take advantage of new opportunities well beyond the challenging traditional telecom business. Hawaiian Telecom is moving to offer television service using Internet technology and hybrid services, blending wireless and wireline capabilities. "We are not daunted when the conventional wisdom says that a sector is out of favor," Kennard told BusinessWeek.com. "Often, that's when you find unique opportunities."

CLOSELY WATCHED. More than money is on the line for Kennard. Before he was appointed to the top job at the FCC by President Bill Clinton in 1997, Kennard had spent most of his career as a lawyer (see BusinessWeek.com, 3/30/98, "Less Sound and Fury at the FCC"). The move to Carlyle, one of the most politically connected private equity firms in the country, is a professional makeover, and the Hawaiian Telecom buyout ranks among high-profile deals that include the purchase of Qwest Communications' (Q) directories business. How Kennard fares could affect his reputation as a dealmaker and as a possible future candidate for public office.

The outcome at Hawaiian Telecom will also be watched closely by the private equity industry. Many of the firms, awash in cash, are eyeing opportunities in telecom. There are roughly 900 independent U.S. regional and rural telcos, and many of them are suffering problems similar to those at Hawaiian Telecom. Traditional landline phone businesses are shrinking as customers opt for wireless phones and Internet phone service. While the cash flow for most of these companies is steady, their prospects are uncertain. "We are seeing a broadband tsunami," says Kennard. "It's literally washing away traditional business models. There are opportunities as a result of this dislocation."

The ranks of these smaller telcos could rise in the coming months. Giants Verizon (VZ) and AT&T (T) are shedding noncore operations. (Hawaiian Telecom was once part of Verizon.) And companies like Sprint Nextel (S) are getting rid of their landline businesses altogether. The company recently spun off Embarq (EQ). Verizon on Aug. 16 said it's considering selling landline businesses in three states—New Hampshire, Maine, and Vermont. Blair Levin, a managing director at Stifel, Nicolaus & Co., says more divestitures by telecom industry giants are likely.

CHECKING OUT THE CASTOFFS. The resulting ailing regional players are often left for dead—and that's where private equity firms like Carlyle, the Blackstone Group, and financiers such as Carl Icahn might come in, says Tom Taulli, an adviser on initial public offerings and mergers and acquisitions. Kennard confirms that Carlyle is looking at smaller U.S. telcos, along with many other investment opportunities, though he didn't say which are of interest.

So what's the appeal of small businesses cast off by telecom behemoths? Though they're among the last to join the broadband revolution, these nimble operations will be among the first to recover, reckons Jonathan Atkin, an analyst with RBC Capital Markets. "Because they have a very specific market focus, they might have decent chances of realizing their goals, offsetting losses, and turning the corner," he says.

But to be competitive, they'll need funds to invest in emerging technologies, such as television services over telecommunications networks, analysts and company executives say. "If you don't reinvent yourself now, it's over," says Michael Ruley, chief executive of Hawaiian Telecom. The company could serve as a beachhead for a sprawling empire, analysts say. "There's going to be a lot of consolidation as these companies try to gain liquidity," says Taulli. "If you combine enough of these companies and gain critical mass, that's when they become interesting."

And the combinations are under way. On Aug. 14, telco Paetech purchased U.S. LEC (CLEC) in a $450 million deal, not including debt.

"HOSTAGED MARKET." Meantime, Hawaiian Telecom is racing to refashion its business. It's pouring money into a high-speed network that would allow for the delivery of TV services as soon as Jan. 1, pending regulatory approvals. Sure, the transformation is expensive, but adding services could revive growth and help Hawaiian Telecom better compete with the state's main cable provider, owned by Time Warner (TXW). "We have here a hostaged market monopolized by this cable provider," says Ruley. "We think there's pent-up demand."

Other new services are on the way, too. In 2007, Hawaiian Telecom will start a major mailing campaign for its Call Choice service, allowing customers to receive cell-phone calls on residential lines (see BusinessWeek.com, 8/14/06, "T-Mobile's Trial Balloon"). Next year, the company will also introduce a dual-mode phone that works on both cellular and Wi-Fi networks. "[These smaller telcos] can well offer new services faster than the big national companies that have the same ideas [but have a lot of territory to cover]," says Sharon Armbrust, an analyst with JupiterResearch.

Still, private equity firms will have a bumpy ride. When it bought Hawaiian Telecom, Carlyle hoped to slash costs by introducing a new back-office system. The move, completed on Apr. 1, has been far from smooth. Systems glitches resulted in billing errors, customer angst, and millions of dollars in expenses.

PATIENCE REQUIRED. Eventually, Carlyle and other equity firms will have the option of exiting businesses through public offerings. "They wouldn't have a problem getting a deal [for Hawaiian Telecom]," says Michael Mahoney, portfolio manager for EGM Capital hedge funds.

But with the speed bumps it has encountered to date and the daunting network overhaul that lies ahead, Carlyle probably won't be able to exit Hawaiian Telecom as quickly as it did Inmedia Communications. It sold the independent British broadcast infrastructure company in July after just two years of ownership.